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Two charts that can predict where the loonie is heading next

The Canadian dollar took a beating this week, by design, as the Bank of Canada cut interest rates to motivate credit growth and spur exports. The future course of the loonie will depend primarily on two factors – commodity prices and Canadian bond yields relative to U.S. Treasury bonds.

The "petroloonie" moniker highlights the importance of commodity prices in determining the value of the domestic currency. It's not just oil prices, either – Bank of Montreal currency analysts believe that while crude prices are an effective leading indicator for the loonie, copper prices are even better.

The Citi Commodity Terms of Trade index measures the commodity prices for resources that Canada exports most. The chart shows the close relationship between the domestic currency and the terms of trade index, particularly during 2015.

The mathematics of correlation coefficients prove the lines move together, but establishing whether the loonie is fair value relative to commodity prices is more difficult to discern by just looking at the chart – it depends on the scale of the y-axis on the chart, which is more subjective. That said, it appears the loonie is at least appropriately valued relative to energy and metals prices and potentially a bit undervalued.

Relative interest rates – the difference between U.S. and Canadian bond yields – is also an important driver of the Canadian dollar. Global investment dollars historically move to higher yielding bonds. For instance, a Canadian pension fund manager will be motivated to sell Canadian bonds and buy U.S. issues of the same duration when U.S. bond yields rise. This is the mechanism by which the Bank of Canada weakens the loonie with interest rate cuts. When central bank Governor Stephen Poloz cuts the benchmark rate, Government of Canada bonds adjust with declining yields and investment flows out of the country.

The second chart shows the dollar compared with the relative yields on U.S. and Canadian two year bonds – the grey line is merely the Canadian two year bond yield minus the U.S. two year Treasury yield.

As with the top chart, the relationship is extremely close. The Canadian dollar has declined along with the yield differential. One year ago, for example, the Canadian two year bond yielded 61 basis points (A basis point is 1/100th of a percentage point) more than the two year U.S. bond and the loonie was at 93 cents. Now, the Canadian two year is yielding 24 basis points less than the Treasury bond, with the loonie closing Friday at 77 cents.

Again, there are limits on how much to conclude on the chart. But in this case, it appears that the yield differential has fallen further than the currency, which suggests the dollar is slightly overvalued relative to the bond market.

The loonie has fallen hard this week and there is a decent chance it's oversold and will see a bounce in the very short term. After that, current signs point to further weakness. The oil and copper markets remain oversupplied for one. In addition, Merrill Lynch economist Emanuel Enenajor wrote, "downside risks to [Bank of Canada] forecasts point to another ease, likely in January, 2016" – which suggests Canadian interest rates are also heading lower relative to U.S. yields.

Currencies, however, are notoriously difficult to predict. Canadians should follow both commodity prices and bond yields for clues.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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